Understanding
Risk
Understanding Risk
Few terms in personal finance are as important,
or used as frequently, as “risk.” Nevertheless,
few terms are as imprecisely defined.
n
Challenge
n
Potential gain
WHAT IS RISK?
In the investment world, risk generally is related to uncertainty.
It refers to the possibility that you might lose your investment
or that an investment will yield less than its anticipated
return. More simply stated, risk has traditionally referred to
the probability that an investment will behave differently
than expected. Every investment carries some degree of
risk because its returns are unpredictable. The more volatile
an investment is—the more unpredictable its returns—the
riskier it is generally considered to be.
In general
Risk is all around us, and we all take risks every day. Some
people consider driving a car risky. Others don’t seem to
mind driving but don’t like flying in an airplane—even though
statistics show you’re far more likely to die in a car than in
an airplane. Some of us, like race car drivers, cliff divers and
bungee jumpers, actually thrive on risk. Others go to great
lengths to reduce risk.
Risk is multidimensional, with many factors interacting. For
example, an athlete in top physical condition may suffer a
fatal heart attack while exercising because he or she has a
family history of heart disease.
Some risks are more apparent than others. For instance,
walking a high wire is quite obviously a risk. On the other
hand, the danger of being struck by lightning is not so
obvious.
The bottom line is that you can’t live without taking some
risks. Since you cannot totally eliminate them, the best you
can do is try to manage them as much as possible. That’s
why we avoid people with colds, eat healthy diets, wear life
jackets when we go boating and buy life insurance.
Risk in the investment world
Some people view risk as a negative, others as an opportunity.
Ask any group of people what risk means to them, and you
are likely to get some of these answers:
n
Danger
n
Possible loss
n
Uncertainty
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Within this framework, there are multiple ways of viewing risk.
Modern Portfolio Theory (MPT), the basis of most portfolio
planning processes since it was articulated in the 1950s,
views risk as being two-sided; the greater an investment’s
deviation from an anticipated return—up or down—the
riskier it is assumed to be. However, a concept sometimes
referred to as Post-Modern Portfolio Theory (PMPT) also has
begun to receive attention. It focuses primarily on downside
risk: the possibility of loss, or of not meeting a specific
investment target. This approach tends to estimate the
statistical likelihood of a negative outcome—for example, the
odds that a portfolio would fail to produce the return needed
to produce a certain level of income for 30 years—and make
plans based on that estimate.
The relationship between risk and return
When you invest, you plan to make money on that investment
or, more accurately, earn a return. Risk and return are inversely
related. In general, the higher the desired return, the greater
the uncertainty about the end result; as a result, you are likely
to have to take more risk to obtain it. Conversely, if you want
a more certain outcome and lower risk, you may have to
accept lower potential return. This is often referred to as the
“risk-return trade-off”; you generally must trade off a higher
potential return in exchange for lower risk.
Understanding Risk
The relationship between risk and time, or the time
horizon
The length of time that you plan to remain in a particular
investment vehicle is known as your “investment planning
time horizon.” Generally speaking, the longer your time
horizon, the more aggressive you may be able to be by
investing in higher-risk investments. This is because the
longer you can remain invested, the more time you’ll have
to ride out fluctuations to try to achieve a higher return
over that time. Of course, there is no assurance that any
investment will not lose money.
Risk-taking propensity
Each individual is able to tolerate a different amount
of investment risk. This is known as your “risk-taking
propensity” or “risk tolerance.” Those who are comfortable
taking more risk in exchange for the potential for a higher
return are referred to as “risk tolerant.” On the other end of
the scale, those who can accept very little risk are known as
“risk averse.” Many people fall somewhere between these
two ends of the risk tolerance spectrum.
There are ways to measure your risk tolerance, using tests
to assess how you react to different types of risk, such as
monetary, physical, social and ethical. These tests aren’t
foolproof, since they generally measure psychological
behaviors that may vary under different conditions and may
or may not take into account how your financial circumstances
affect your risk tolerance. However, the results from these
tests are generally considered reliable and valid.
In determining which investments match your risk-return
expectations, your risk-taking propensity is as important as
the risk of a given investment itself. If your risk tolerance
proves to be lower than you initially thought, you may have
difficulty sustaining a financial plan during difficult periods.
Also, your risk tolerance may change over time as your
circumstances change.
HOW DO YOU EVALUATE THE RISK OF A SPECIFIC
INVESTMENT?
Before you can evaluate the risk of a specific investment,
you must understand the types of risk that exist and how to
measure them.
As in your day-to-day life, risks are prevalent in the
investment world, and some are more apparent than others.
Each investment is subject to all of the general uncertainties
associated with that type of investment. These are known
as “systematic risks” and include market, interest rate and
purchasing power risk, among others. Risk also arises from
factors and circumstances that are specific to a particular
company, industry or class of investments. These are known
as “diversifiable” or “unsystematic” risks, because they can
be addressed (at least in part) by investing in more than
just that one company, industry or class. Diversifiable risks
include business, financial and default risk, among others.
Measuring risk involves analyzing the various types of
risk using an array of mathematical tools and techniques
(e.g., an investment’s standard deviation, beta, alpha and
so forth). The statistics obtained provide an investor with
some standardized measurements with which to make an
educated decision.
Rating services
Rating services, such as Standard & Poor’s, Fitch, Moody’s,
Value Line and Morningstar, compile and publish risk and
return statistics for many types of investments. Though they
are not infallible, these services provide an investor with key
information and statistics in a condensed and easy-to-read
format, and often give some context for assessing the data.
To obtain rating service reports, check with your public
library. It may subscribe to some or all of these services. You
also may find information online.
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Understanding Risk
RESEARCH
To do investment research, you may be able to view an
annual report, prospectus or proxy statement with financial
information and outlined business strategies. To obtain
copies of these documents, contact the issuer of the security.
You also may find helpful information in books, newspapers,
magazines, journals, newsletters or online sources.
HOW DO YOU REDUCE RISK?
Diversify
One of the most common ways to reduce risk is to develop
a portfolio of investments that is balanced in terms of
the types of assets in which you invest. In other words, in
designing and managing an investment portfolio, don’t put
all your eggs in one basket. This is known as “diversification.”
According to Modern Portfolio Theory, a portfolio that
mixes a variety of asset classes (e.g., cash, bonds, domestic
and foreign stocks, and real estate) generally has a lower
risk for a given level of return than a portfolio that consists
of only one of those classes or a portfolio with assets that
are highly correlated and tend to behave in similar ways.
Diversification works because it broadens your investment
base (though it can’t guarantee a profit or protect against a
possible loss). It can be achieved by company, industry, type
of security, markets or by investment objective.
How an investor diversifies depends upon his or her own
situation. An investor can be aggressive (investing mostly in
high-risk vehicles), conservative (investing mostly in low-risk
vehicles) or somewhere in between (often by using some
combination of high- and low-risk investments).
Allow for the passage of time
Historically, time has helped moderate the riskiness of some
investments (though there is no guarantee this will continue
in the future). In “investmentspeak,” the standard deviation
associated with the average rate of return on an investment—
the extent to which returns vary from historical norms—tends
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to decrease over time. In plain English, the longer the investor
remains invested—or the longer the investor’s time horizon—
the more the return over that time will tend to resemble the
historical average.
Do your homework
You may be able to reduce some risk simply by being diligent.
For example, have real estate inspected and appraised before
you buy it, or investigate a company’s financial condition
before you purchase stock in it.
Gauge the economy by identifying trends in overall business
conditions. These trends are indicated regularly (weekly or
monthly) by figures on inventories, prices, employment and
the GDP. Is the economy on an upswing or downswing?
Knowing this will help you choose an investment you believe
is likely to appreciate under the given conditions.
Make sure you understand why you’re buying an investment
and what role you want it to play in your portfolio. In addition
to making you a more informed investor, this also can help
you gauge when to sell it. n
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